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A few of the financial market’s best minds on U.S. inflation are coalescing around the view that core readings, which matter most to Federal Reserve policy makers, are set to fall in a matter of months.
One of them is Tim Magnusson, chief investment officer of the fixed income relative value strategy at Minnesota-based Garda Capital Partners. A year ago, he accurately predicted that the annual headline rate from the consumer price index would be above 7% at the end of 2022. (December’s release of the CPI showed a 7.1% rate for November). Now, Magnusson expects the narrower core CPI reading, which strips out food and energy, to head down like the annual headline rate, which fell to 4% for May from a 9.1% peak last June.
Read: Trader who predicted inflation pain now sees an end to persistent price gains: ‘This round is over.’
“Core inflation is likely to slow in the months ahead, but there remains, as always, uncertainty on the ultimate level where core inflation settles,” Garda’s Magnusson said in an email to MarketWatch. “The bottom line for us at Garda is that inflation is coming down,” which is “now obvious” given the drop in the annual headline CPI rate to 4% from more than 9% a year ago. “We think the same will happen to core over the next several months” as pressure on used-car prices subsides. Rent and owners’ equivalent rent increases should also continue to moderate, he said.
Magnusson’s comments came on a day in which four central banks in Europe all raised interest rates, putting the threat of persistent worldwide inflation back on the radar for investors.
Major U.S. stock indexes
DJIA,
COMP,
finished mostly higher on Thursday, after struggling during much of the New York session. Meanwhile, two-year
TMUBMUSD02Y,
through 30-year Treasury yields
TMUBMUSD30Y,
advanced and one of the bond market’s most reliable recession indicators — the spread on 2- and 10-year rates — intermittently dipped to minus 100 basis points in a troubling sign about the outlook.
Helping to temper fears about stubborn price gains was Fed Chairman Jerome Powell, who told the U.S. Senate Banking Committee on Thursday that inflation could possibly cool without a large increase in the unemployment rate. Powell’s view offered a glimpse into some of the optimistic thinking that’s surfaced behind the scenes in financial markets about inflation’s most likely path forward.
On Wednesday, Deutsche Bank strategist Gabriele Cozzi and researcher Matthew Raskin said they see the Fed’s favorite inflation gauge — the core personal consumption expenditures price index — falling even further than the U.S. central bank thinks by year-end.
And traders of derivatives-like instruments known as fixings, who can make or lose millions of dollars on a single trade, expect the headline CPI rate to fall to 3% on a year-over-year basis for June and stay around that level through September, before starting to head toward 2% in October.
Source: Bloomberg. Data as of Thursday.
Core readings of inflation matter most to the Fed because they tend to reflect a purer read on inflation that isn’t distorted by the volatile items of food and gas. Based on the CPI, core inflation has remained stubbornly stuck at 0.4% or higher on a monthly basis from December to May. The counterpart PCE index has seen its core readings stay between 4.6%-4.7% on an annual basis during the first four months of this year.
What makes Magnusson’s view so surprising is that, only a week ago, stubborn core readings were the main reason that Fed policy makers penciled in two more quarter-of-a-percentage-point rate hikes for 2023. On Wednesday, Powell acknowledged that U.S. inflation has been partly driven by dynamics created from the pandemic, a notion that should theoretically make it harder for prices to come down in a timely way. High inflation in Europe should also be supporting the idea that persistent price gains in the U.S. aren’t likely to go away soon.
However, the Garda executive isn’t alone in his thinking, which could help fuel another rally in stocks if his view comes to fruition and might put equity investors on the right side of the inflation debate for a change. Gang Hu, an inflation trader at New York hedge fund WinShore Capital Partners, said that the fixings market is implying “a roughly 2.5%” core CPI rate for the next 12 months, based on his own model. That compares with a 5.3% annual core CPI reading for May.
This breaks down into readings that are roughly half of where they are now. In Garda’s view, “the inflation fixing market is pricing in a deceleration in core inflation in the coming months from a run rate of north of 40 basis points/month so far in 2023,” or 0.4% on a monthly basis, “towards a 20bps run rate heading into the second half of the year,” Magnusson said. Run rate refers to what Garda thinks will be the normal monthly rate for the rest of the year.
A core inflation run rate of close to 20 basis points, or 0.2%, “is more consistent with the Fed’s inflation target,” Magnusson said. “So, in short, as the next several prints come in, it looks like they will come as good news to the Fed members who have been citing core inflation as a concern.”
Garda is a hedge-fund firm that had more than $9 billion in institutional assets as of May 31.
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